The Role of Value Investing in a Post-COVID World
In late January, the Money Maze Podcast welcomed guest C.T. Fitzpatrick from Vulcan Value Partners onto the show to discuss what he classes as a “high-quality businesses”. But with volatility and uncertainty at an all-time high as Russia continues its invasion of Ukraine, the ability of these investments to withstand downward pressure will become clearer.
The value of a company is dependent on a plethora of inputs, for Fitzpatrick these include the use of free cash flow, a strong balance sheet and a sustainable competitive advantage. The foundation for maintaining stable value is free cash flows without consuming it for growth, whilst a strong balance sheet can be identified by the use of free cash flows to cover the maturities of a company, as well as net cash being used to protect its competitive advantage (hence increasing the company's competitive advantage).
After applying the numerous criteria, VVP has dwindled their investment pool down to 600 eligible companies, of which only a fraction make it onto the mutual funds and managed accounts.
Fitzpatrick discussed the process of re-evaluation of investments when COVID-19 burst onto the scene; I suspect a similar approach has been taken in response to the Russo-Ukrainian war. The process was split into three stages, the first, applying a stress test to all companies to see if they could withstand greater than 3 standard deviation events (a 3 standard deviation event covers more than 99% of the time). To say with certainty that VVP know/can model all 3 standard deviation events is a bold statement to make, let alone to assert that the vast majority of their companies withstood this stress test.
A more realistic approach for Fitzpatrick to make, would be to say that VVP has a high degree of confidence in the cash flow and debt structure of its chosen companies, to weather greater than 3 standard deviation events. For those companies where confidence is lacking, the proceeds generated from selling them would allow VVP to buy other companies at discounted prices. Thus, forming the second stage.
Fitzpatrick would also sell companies that saw stock price increases but maintained stable value - as net price to book value (P/B) was higher & therefore riskier. The result? Driving the weighted average P/B of the portfolio down to 50%. The final stage is to analyse which companies have their competitive advantage strengthened due to the event and move the portfolio to become more competitively entrenched, hence increasing the value growth.
Although the true ramifications of the ongoing invasion are yet to be seen, it can be suspected that there will be continued inflationary pressure despite the quantitative tightening from both the Federal Reserve and Bank of England, after loose monetary policy was implemented at the start of the pandemic. The show’s host, Simon Brewer, alluded to record high operating margins because of rising material costs and freight prices back in late January. There is no sign of these slowing down, as uncertainty regarding global supply chains and the imports of Russian metals, fuel and jewellery are slamming to a halt due to the sanctions from western nations.
The implications of record high inflation and uncertainty about the ongoing war can be seen in the 20% fall in the S&P 500. This volatility may concern some but with the active share of VVP being 99, the portfolio should not react in the same way as the markets. Although this means it will be different, it does not mean their performance will necessarily be better - the flagship ‘partners fund’ is down almost 40% in the same 6-month window.
If Fitzpatrick is right however about his stable value companies that can withstand 3 standard deviations events, the portfolios of VVP should stand in good stead as the undervalued companies start to receive the attention they deserve.
By Timothy Carter, part of the Money Maze Podcast Ambassador Programme. Tim is an undergraduate studying economics at Durham University, and has got involved in the Durham University Finance Society as a fund analyst.
This content does not constitute any form of advice, recommendation, representation, endorsement or arrangement, and should not be used to make any investment decisions. Our full disclaimer is available below.
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In this conversation, Vulcan’s C.T. Fitzpatrick explains the skills he acquired during 17 years at South Eastern Asset Management before founding Vulcan Value Partners in 2007.
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